On the Relation Between Expected Returns and Implied Cost of Capital

24 Pages Posted: 18 Apr 2008

See all articles by John S. Hughes

John S. Hughes

University of California at Los Angeles

Jing Liu

The Cheung Kong Graduate School of Business

Jun Liu

University of California, San Diego (UCSD) - Rady School of Management

Date Written: April 15, 2008

Abstract

In this study, we examine the relation between implied cost of capital and expected returns under an assumption that expected returns are stochastic, a property supported by theory and empirical evidence. We demonstrate that implied cost of capital differs from expected return, on average, by a function encompassing volatilities of, as well as correlation between, expected returns and cash flows, growth in cash flows, and leverage. These results provide alternative explanations for findings from empirical studies employing implied cost of capital on the magnitude of the market risk premium; relations between cost of capital, growth, leverage, and idiosyncratic risks; predictability of future returns, and characteristics of the firm's information environment.

Keywords: expected return, implied cost of capital, discount rate

JEL Classification: G10, G12

Suggested Citation

Hughes, John S. and Liu, Jing and Liu, Jun, On the Relation Between Expected Returns and Implied Cost of Capital (April 15, 2008). Available at SSRN: https://ssrn.com/abstract=1028882 or http://dx.doi.org/10.2139/ssrn.1028882

John S. Hughes

University of California at Los Angeles ( email )

D410 Anderson Complex
Los Angeles, CA 90095-1481
United States
310-794-9553 (Phone)
310-267-2193 (Fax)

Jing Liu (Contact Author)

The Cheung Kong Graduate School of Business ( email )

1 East Changan Avenue, Oriental Plaza
E3/3F
Beijing
China

Jun Liu

University of California, San Diego (UCSD) - Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States
858.534.2022 (Phone)
5858.534.0745 (Fax)

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